Managerial Accounting Course

Managerial Accounting Course

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Return on Average Investment

Measuring the return of an investment is a good way of understanding the profitability of a given project or investment.

Return on average investment (ROI) uses two basic inclusions: initial investments and the net income. The initial investments are the cost of the investment while the net income is the cash inflows associated with the investment.

ROI Formula

The formula to calculate ROI is;

ROI = Average Estimated net income / average investment

The average net income is the average of period cash inflows resulting from an investment. To determine the average investment, the original investment amount and any residue or salvage costs as a resulted of disposal of the initial investment are considered.

To put that in an equation, it will mean that if a company buys a tractor for $100,000 and uses it for five years receiving an annual net income of $12,000 and then sales it for $20,000, the average investment will be (100,000 + 20,000)/2 = $60,000.

The ROI for this example will be:

ROI = Average Estimated net income / average investment

ROI = 12,000 / 60,000

ROI = 0.2 or 20%

The return on average investment for this investment is 20%. The management has to compare this rate of return with the current rate of return of other investments to determine if the investments is profitable to pursue.

The investment with a higher ROI is chosen over an investment with a lower rate of return.

Example of ROI - Scenario

Let's use the earlier example (from Payback method) to determine the ROI. Company X plans to invest in a project costing $100,000 as the initial investment, and the company expects an annual net cash flow of $20,000 per year. The company expects to dispose its initial investment after 15 years for $60,000. What is the rate of return for the investment?

Solution to ROI Example

ROI = Average Estimated net income / average investment

ROI = 20,000 / 80,000

ROI = 0.25 or 25%

The rate of return for the example is 25%. As earlier stated, the management has to compare the interest with other investment opportunities to make a decision of whether the investment should be pursued or not.

From the two capital budgeting methods (payback period and ROI), we can see that the time value of money is not considered or included in the formulas, and this is the biggest shortcoming of the two methods. And thus, even though the two methods can be used in capital budgeting, they alone cannot be relied upon to offer a satisfactory informed decision.

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